Economics, 3rd Edition

Principle 7: Governments Can Sometimes Improve Market Outcomes

If the invisible hand of the market is so wonderful, why do we need government? One answer is that the 

invisible hand needs government to protect it. Markets work only if property rights are enforced. A farmer 

won’t grow food if he expects his crop to be stolen, and a restaurant won’t serve meals unless it is assured 

that customers will pay before they leave. We all rely on government provided police and courts to enforce 

our rights over the things we produce.

Yet there is another answer to why we need government: although markets are usually a good way 

to organize economic activity, this rule has some important exceptions. There are two broad reasons for 

a government to intervene in the economy – to promote efficiency and to promote equity. That is, most 

policies aim either to enlarge the economic cake or to change the way in which the cake is divided.

Although the invisible hand often leads markets to allocate resources efficiently, that is not always the 

case. Economists use the term 

market failure

 to refer to a situation in which the market on its own fails to 

produce an efficient allocation of resources. One possible cause of market failure is an 

externality

, which 

is the uncompensated impact of one person’s actions on the well-being of a bystander (a third party). For 

instance, the classic example of an external cost is pollution. Another possible cause of market failure 

is 

market power

, which refers to the ability of a single person or business (or group of businesses) to 

unduly influence market prices. In the presence of market failure, well designed public policy can enhance 

economic efficiency.